Including updates on crowd funding and G20 summits

Crowding out supply-side constraints to investment

On 27 March 2014, the European Commission (EC) adopted a package of measures looking at new and different ways of stimulating long-term financing and investment across Europe. The EC is taking a multi-dimension approach to encourage different forms of long-term investment to supplement bank financing on which Europe too heavily relies on at the moment. They want to remedy the current malaise about long-term investment as investors remain skittish about the Continent’s long-term growth prospects. The new package covers most areas, from developing capital markets, making better use of public funds, mobilising savings and opening up the occupational pensions fund market in Europe.

A key element of the strategy is promoting the development of crowdfunding. Crowdfunding involves a number of individuals investing, or lending, a relatively small amount of money to a business. One popular type, known as peer-to-peer lending, enables borrowers to tap loans directly from savers through internet-based platforms. Other forms of crowdfunding involve making equity investments, usually in start-up companies. Crowdfunding has the potential both to bridge the financing gap for many start-ups and to provide much needed returns for yield-strapped investors grappling with low interest rates, particularly in an environment where enhanced prudential capital requirements will continue to constrain bank finance. Expanding the crowdfunding ‘pot’ could help start-ups to move up the "funding escalator" and contribute to building a pluralistic and resilient social market economy.

This rapidly growing sector claims to offer a better deal than traditional banks or venture capital houses by cutting out the ‘middle man’. While crowdfunding platforms often charge a fee to assist with publishing campaigns and collecting funds, those charges are usually small compared to the margins that banks or other finance providers require. In 2012, crowdfunding in Europe grew by an estimated 65% compared to 2011, reaching €735 million. This growth is promising compared to the shrinking European venture capital market of €3 billion, but is still small compared to the European initial public offering (IPO) markets of around €16.5 billion. The UK has the most advanced crowdfunding market in Europe. In the last three years, crowdfunding has trebled in size in the UK–exploiting the gap left as banks retreat from lending. The UK market could be worth £1 billion by 2016, according to the Open Data Institute, if it continues to grow at its current rate.

The EC doesn’t want to quash crowdfunding, distort the current market or scare-off new entrants. It would like to see it ‘flourish’ across all Member States. It intends to establish an expert group on crowdfunding to provide advice, particularly in terms of exploring the potential of establishing a “quality label” to build trust with users, and providing expertise in promoting transparency, best practices and certification. The EC will work on raising the sector’s profile by promoting information and training as well as raising standards. It also intends to map national regulatory developments and hold regulatory workshops, to assess if regulatory intervention is necessary at EU level, following regulatory intervention in some Member States.

Crowdfunding presents some promising opportunities for European businesses but also some potential risks for investors and financial markets. Start-ups often find it difficult to raise funds – the odds against creating another ‘Google’ or at least a viable business often seem to be stacked against entrepreneurs. Do small crowdfunding investors really understand the risks they are taking? Banks with advanced credit risk systems and deep pockets are likely to be in a better position to assess risks and bet on nascent businesses than individual investors. Investing in start-ups also carries risks of fraud (i.e. when the money collected is not used for the stated purposes), misleading advertising or other shenanigans suckering unsuspecting investors. Regulators will need to monitor and address these risks as crowdfunding increases.

Some of these risks can be alleviated by effective regulation which could help boost the fledgling industry and add legitimacy to new online finance models. First out of the blocks, the US Securities and Exchange Commission (SEC) published 585 pages of proposed crowdfunding rules on 23 October 2013. Under the 2012 Jumpstart Our Business Startups Act, the SEC was mandated by Congress to look at loosening certain restrictions to make it easier for small companies to raise capital on internet platforms. It grappled for a year on how to hit the right tone but has finally decided that intermediaries can rely on investors to vouch for themselves in terms of appropriateness (subject to some restrictions on how much a person can invest). This development is seen as a major win for crowdfunding operators.

The new rules also introduce pretty run-of-the-mill transparency requirements for businesses seeking investment. Budding ‘WhatsApps’ would be required to provide information to prospective investors about their business plan and financial condition, as well as a list of significant investors. The new rules have won praise from lawmakers and crowdfunding operators alike according to press reports and could fundamentally change how start-ups are financed in the future.

The UK is on a similar path. The UK Financial Conduct Authority (FCA) finalised it regulatory approach to crowdfunding and similar activities (PS14/4) on 6 March 2014. The new rules will make the market more accessible to retail investors, foster competition and facilitate access to alternative finance options. But the FCA wants to ensure that only investors who are able to understand and bear the risks participate in this market.

Can the UK, or any individual EU country, create a sufficiently liquid market? Probably not, and the EC seems to agree. It is exploring how EU action, including a range of soft-law measures, could promote crowdfunding. Its ultimate objective is to gather data about the needs of market participants and to identify the areas where encouraging the growth of this new industry adds value, either through facilitative, soft-law measures or legislative action.

The EC knows that it needs to tread carefully here. Regulation has the potential to kill off this new financing model entirely but a lack of regulation could have the same effect if investors have bad experiences early on. Introducing appropriate safeguards makes sense to ensure that investors are fully aware of the risks that they are taking. As long as regulation is designed to make market processes work better (i.e. matching small investor’s needs with crowd financiers’ risk and return appetite) it will help develop this market, preserving its complementary nature to traditional bank lending and capital markets. Investors – banks and other institutional investors, venture capitalists, angel investors - may provide valuable insights on how to frame appropriate regulatory protections while ensuring this embryonic market flourishes. Brussels wants to work harder to ensure growth. Crowdfunding may be an easy win for politicians but likely to remain a small source of funding for the foreseeable future. Lack of finance is only one challenge facing EU businesses - EU politicians are also working to help business by implementing challenging structural reforms in the labour market, trying to cut red tape and harmonising insolvency laws across borders to help start-up and small businesses.

G20 summits: do markets care?

Ever since the Pittsburgh summit in 2009, the G20 has been the driving force behind the international response to the financial crisis, from Basel III’s new capital and liquidity regime, the too-big-to fail initiative and the clearing of OTC derivative contracts through central counterparties. These reforms, collectively, will transform how financial markets operate.

The consequence of the G20 taking the reins from G7 has been undoubtedly good from a global governance perspective, enabling key emerging markets to be represented at the decision making table. Anecdotally it has enabled a more joined-up and consistent approach to economic governance—which was markedly absent following the Great Depression.

But its impact on financial markets is less clear-cut. While it is not the objective of the G20 to steer global financial markets, especially in the short term, the markets’ reaction is a useful indicator of the information and hence decision content of G20 summits. If the G20 summits contribute to reaching consensus on key decisions in financial regulation, it should follow that summits represent important news for financial markets and should be reflected in market prices and volatilities.

Lo Duca and Stracca at the ECB considered this issue, examining the impact of G20 summits on market prices in their paper, “The Effects of G20 Summits on global financial markets”. The authors analysed the impact of the G20 meetings of both leaders and ministers on a set of financial market prices: “equity, bond markets, as well as equity implied volatility and higher moments such as skewness and kurtosis, to also capture the effect on asymmetry and tail risks”. Studying the impact on volatility is particularly useful to understand whether the G20 has been a stabilising force on markets.

The empirical results show that, with a couple of exceptions, the market effects of G20 summits are “small, short-lived, non-systematic and non-robust across specifications and assets”. The paper also shows that the characteristics of the statements released after the meetings and of the press reception likewise do not have a consistent effect on markets. It might be that the markets see G20 pronouncements as just being too separated in time from the realities of actual implementation in its member countries to merit an immediate reaction. Measures agreed at the G20 level inevitably face lengthy local legislative processes and are inevitable adapted to local contexts. Nevertheless there is some evidence, though not very strong, that G20 summits have had a mild calming impact on market developments.

But an important caveat applies to this analysis: it is limited to the short term reaction of financial markets. It may very well be that decisions at the G20 level have helped in stabilising global financial markets from a longer term perspective and have averted a more negative scenario which might have materialised in the absence of such mechanism. This longer-term perspective is a much harder question to tackle and, ultimately, might not be that insightful. The long-run is a misleading guide to current affairs because, as John Maynard Keynes said, in the long run we are all dead.